In the past few weeks, I have seen various analysts and commentators stating that either the Fed has fumbled the delivery of its message, or that even if it tapers, the effects will be minor. Here is one example from Comstock Partners:

Last week we wrote that Bernanke could not be happy with the way long bond rates reacted to his press conference answer that the Fed could begin lessening its rate of bond purchases in the next few months, and that he would attempt to sooth the market in yesterday’s press conference following the FOMC meeting. Well, he tried, but ended up making things worse, at least in the perception of the markets.

The Chairman attempted to allay fears by setting specific dates and economic parameters for reducing and eventually eliminating the latest bond purchase program that, until recently, was assumed by the market to be open-ended. He further took pains to assure the markets that just reducing the amount of purchases was not the same as tightening and that the fed funds rate would not likely be increased before early in 2015. He also assured one and all that the decisions would still be data-dependent, and subject to adjustment.

Investors, however, took what Bernanke apparently thought was increased clarity to mean greater hawkishness, and, as a result, bond yields soared as stocks tanked. In addition the markets gave far greater importance to the potential reduction of bond purchases, whereas the Fed attached greater significance to the continuing expansion of their balance sheet.

A history lesson: We want you to take risk
To the contrary, I believe that the Bernanke Fed knows exactly what it is doing with its communications policy. Remember what the intent of the various quantitative easing programs were designed to do. The intent of QE is to lower interest rates, lower the cost of capital and lower the risk premium. In the wake of the Lehman Crisis of 2008, the Fed stepped in with QE1. It followed with QE2 and QE3, otherwise known as QE-Infinity. The Fed first lowered short rates, told the market that it was holding short rates down for a very long, long time. It then followed up with purchases of Treasuries further out on the yield curve and later started to buy Agencies as well in order.

The message from the Fed was: “We want you take take more risk.” Greater risk taking meant that businesses would expand, buy more equipment, hire workers, etc. It hoped to spark a virtuous cycle of more sales, more consumer spending and to revive the moribund real estate market. Moreover, banks could repair their balance sheets with the cheap capital.

Imagine that you are a bank. The Fed tells you that it is lowering short rates and holding them low for a long time. That is, in essence, a signal to borrow short and lend long. In the summer of 2009, T-Bills were yielding roughly 0.5% and 10-year Treasuries were roughly 3.5%. If the bank were to borrow short and lend long with Treasury securities (no credit risk), it could get a spread of roughly 3%. Lever that trade up a “conservative” 10 times and you get a 30% return. 20 times leverages gets you 60% return. Pretty soon, you’ve made a ton of money to repair your balance sheet.

The banks weren’t the only ones playing this game. The hedge funds piled into this trade. Pretty soon, you saw the whole world reaching for yield. The game was to borrow short and lend either long or to lower credits. Carry trades of various flavors exploded. There were currency carry trades, some went into junk bonds, others started buying emerging market paper. You get the idea.

The net effect was that not only interest rates fell, Risk premiums fell across the board. The equity risk premium compressed and the stock market soared. Credit risk premiums narrowed and the price of lower credit bonds boomed.

Managing the exit
During these successive rounds of quantitative easing, analysts started to wonder how the Fed manages to exit from its QE program and ZIRP. We all knew that the day would have to come sooner or later. So on May 22, 2013, Ben Bernanke stated publicly that the Fed was considering scaling back its QE purchases, but such a decision was data dependent.

Our results provide some grounds for optimism about the likely efficacy of nonstandard policies. In particular, we confirm a potentially important role for central bank communications to try to shape public expectations of future policy actions. Like Gürkaynak, Sack, and Swanson (2004), we find that the Federal Reserve’s monetary policy decisions have two distinct effects on asset prices. These factors represent, respectively, (1) the unexpected change in the current setting of the federal funds rate, and (2) the change in market expectations about the trajectory of the funds rate over the next year that is not explained by the current policy action. In the United States, the second factor, in particular, appears strongly linked to Fed policy statements, probably reflecting the importance of communication by the central bank. If central bank “talk” affects policy expectations, then policymakers retain some leverage over long-term yields, even if the current policy rate is at or near zero.

The market misses the point
From my read of market commentaries, I believe that analysts are focusing too much on the timing and mechanics of “tapering” and not on the meta-message from the Fed. If quantitative easing is meant to lower interest rates and lower the risk premium, then a withdrawal of QE reverses that process.

In effect, the Fed threw several giant parties. Now it is telling the guests, “If things go as we expect, Last Call will be some time late this year.”

Imagine that you are the bank in the earlier example which bought risk by borrowing short and lending long, or lending to lower credits in order to repair your balance sheet. When the Fed Chair tells you, “Last Call late this year”, do you stick around for Last Call in order to make the last penny? No! The prudent course of action is to unwind your risk-on positions now. We are seeing the start of a new market regime as risk gets re-priced.

That’s the message many analysts missed. The Fed is signaling that risk premiums are not going to get compressed any further. It will now be up to the markets to find the right level for risk premiums. Watch for Ben Bernanke to elaborate on those issues on Wednesday*. In the July 4 edition of Breakfast with Dave, David Rosenberg wrote the following about the Fed’s communication policy:

I actually give Bernanke full credit for giving the markets a chance to start to price that in ahead of the event, and to re-introduce the notion to the investment class that markets are a two-way bet, not a straight line up. Volatility notwithstanding, I give Berananke an A+ for shaking off the market complacency that came to dominate the market thought process of the first four months of the year (to the point where the bubbleheads on bubblevision were counting consecutive Tuesdays for Dow rallies). Ben’s communication skills may be better than you think – underestimating him may be as wise as underestimating Detective Columbo, who also seems “awkward” but was far from it.

Bernanke knows exactly what he is doing when he hints about tapering in his public remarks. It’s the risk premium, stupid! And it’s going up.

Earnings to do heavy lifting
With this shift in tone, don’t expect the Fed to push yields down anymore. The Fed won’t be pushing you to take as much risk. Consider what this means for stocks. If the economy does truly take off and earnings grow, then stock prices can rise. However, don’t expect stock prices to rise because P/Es are going to go up because the Fed is pushing the market to take more risk. In fact, P/Es are more likely to fall and it will be up the the E component of that ratio, namely earnings, to do the heavy lifting.

As we approach Earnings Season, the task may be more difficult. Thomson-Reuters reports that negative guidance is high compared to recent history:

As the beginning of the second-quarter earnings season approaches, the negative guidance sentiment is weighing on analyst estimates. So far, S+P 500 companies have issued 97 negative earnings preannouncements and only 15 positive ones, for a negative to positive ratio of 6.5. The guidance has contributed to the downward slide in second quarter growth estimates, with EPS currently estimated to grow 3.0%, down from the 8.4% estimate at the beginning of the year.

Analysts have an even bleaker outlook for the top line. After a first quarter when S+P 500 companies reported an aggregate revenue growth rate of 0.0%, the consensus currently calls for 1.8% growth in the second quarter. With revenue growth holding back earnings for the past several quarters, we did an evaluation of company management teams’ outlooks for their revenues. Over the time period evaluated, Q1 2008–present, revenue preannouncements were more balanced than were EPS preannouncements. On average, there were 1.7 negative revenue preannouncements for each positive one. This compares with an N/P ratio of 2.4 for EPS over the same period.

The stock market is facing headwinds. This is a regime shift. Markets generally don’t react well to regime shifts and inflection points like these. Expect volatility and an intensee focus on headlines. The path of least resistance for stock prices, notwithstanding a robust economic recovery, is down.

* Ben Bernanke is expected to take questions after his speech. If anyone who is reading this happens to be there, please ask the following for me: “Mr. Chairman, it appears that the latest round of quantitative easing where the Fed bought Agencies instead of Treasuries was inteneded to narrow the risk premium between the two asset clases. Would it fair to conclude that when the Fed starts to wind down its QE program, risk premiums are expected to widen their natural market determined levels?”

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Since 2008, I have seen various analysts criticizing the Fed, ECB and other central banks for their efforts at quantitative easing and other forms of unconventional monetary policy. These policies have been criticized as less than effective. One such analyst is Stephen Roach, formerly of Morgan Stanley:

While the Fed’s first round of quantitative easing helped to end the financial-market turmoil that occurred in the depths of the recent crisis, two subsequent rounds – including the current, open-ended QE3 – have done little to alleviate the lingering pressure on over-extended American consumers. Indeed, household-sector debt is still in excess of 110% of disposable personal income and the personal saving rate remains below 3%, averages that compare unfavorably with the 75% and 7.9% norms that prevailed, respectively, in the final three decades of the twentieth century.

Now that the Fed is hinting that it is thinking of taking its foot off the accelerator, we are now seeing the reversal of some of the effects of QE – and it’s sent the markets into convulsions. The intention of all these unconventional policies was to bring down interest rates and push the market into taking more risk. As a result, asset prices have soared and risk premiums have shrunk. Just look at this chart from Zero Hedge:

Now that the Fed is hinting that it is thinking about unwinding these programs, which Fed officials have quick to distinguish between taking the foot off the gas (tapering) and stepping on the brakes (tightening), risk premiums have begun to rise and asset prices have fallen. This chart from Gwyn Davies show that, despite Fed officials communications policy, the market has de facto tightened in spite of Federal Reserve actions:

Consider the effects of this reversal:

Treasury bond yields have spiked. The Fed’s began with lowering short-term rates, progressed to buying Treasuries further out on the yield curve and finally added agencies to its purchases. Now that the Fed has signaled that it is considering winding down its QE program, Treasury yields have spiked.

It has caused carnage in the Eurodollar market. If you hold down short rates and then tell the world that you expect to hold short rates at zero or near zero for a long, long time, it is an invitation to Mr. Market to put on a carry trade – and it did, with leverage. The signal of reversal is causing these carry trades to unwind, the most obvious of which is the “get cheap funding and buy Eurodollar deposits” trade. See Vince Foster’s Minyanville articleBernanke’s Misfired Shot Heard ‘Round the World.

Other carry trades like the currency carry trade are being unwound in a disorderly manner.

The Fed’s implicit encouragement for the market to take risk pushed funds into junk and emerging market bonds. We have seen how investors reached for yield in the last few years, some of that money made its way into lower quality credits like junk bonds and emerging market bonds. In particular, the emerging market bond market has sold off in a frenzy. In addition, it has caused stress in a number of EM currencies as the market has begun to re-calibrate risk premiums.

The market’s reach for yield likely played a role in China’s latest shadow banking bubble and recent liquidity squeeze. Michael Pettisexplained the carry trade this way:

Over the last two years, and especially in 2013, mainland corporations with offshore affiliates had been borrowing money abroad, faking trade invoices to import the money disguised as export revenues, and profitably relending it as Chinese yuan. As China receives more dollars from exports and foreign investment than it spends on imports and Chinese investment abroad, the People’s Bank of China, the central bank, is forced to buy those excess dollars to maintain the value of the yuan. It does this by borrowing yuan in the domestic markets. But because its borrowing cost is greater than the return it receives when it invests those dollars in low-earning U.S. Treasury bonds, the central bank loses money as its reserves expand. Large companies bringing money into the mainland also force the central bank to expand the domestic money supply when it purchases the inflows, expanding the amount of credit in the system.

In May, however, the authorities began clamping down on the fake trade invoices, causing export revenues to decline. Foreign currency inflows into China dried up, as did the liquidity that had accommodated rapid credit growth. The combination of rapidly rising credit and slower growth in the money supply created enormous liquidity strains within the banking system. This is probably what caused last week’s liquidity crunch and this week’s market convulsions.

When Pettis wrote that Chinese companies imported foreign money and engaged in the practice of “profitably relending it as Chinese yuan”, he is referring to injections into China’s shadow banking system, which is really their subprime market. In a separate note, Izabella Kamanska of FT Alphaville also documented analysis from Deutsche’s Bilal Hafeez indicating that the tight USD-CNY relationship was ripe for a carry trade.

Tapering talk has devastated the TIPS market. As the market has contemplated the reversal of QE, inflationary expectations have plummeted and so have the price of TIPS.

QE first buoyed commodity prices and now we are seeing the reversal of that trade. Gold and other hard commodities benefited from low and negative real interest rates. Now that we are seeing real interest rates rise (and inflationary expectations fall), commodity prices are getting hammered.

Tapering talk has also implicitly hurt Europe. The ECB has been able to stabilize the eurozone with Draghi’s “whatever it takes” remark and the unveiling of its OMT program, which has not been activated yet. Yield spreads of peripheral countries’ bonds against Bunds have narrowed because of the ECB’s threat of action, along with the flood of global liquidity. Now that the flood of global liquidity is starting to recede, the ECB may actually have to resort to OMT, which would cause another round of euro-angst and more risk premium re-calibration.

I’ve probably forgotten or missed out on some other side effects of the various rounds of Fed QE, but you get the idea. Many of these bets were leveraged bets as they were designed to help banks profit and repair their balance sheets, e.g. the Eurodollar carry trade. When these trades unwind, the effects will not a blip, but a tsunami.

All these macro effects are suggesting that we are at the start of a risk re-pricing process that will take months to complete. It will not be friendly to asset prices at all.

Earnings headwinds
In the US, stock prices are starting to face headwinds from a deteriorating earnings outlook. Ed Yardeni documented that while Street earnings estimates continue to rise, forward sales estimates are falling. How long can this divergence continue? Can margins continue to rise?

One way of boosting earnings per share while the sales outlook is punk is to buy back shares. If you reduce the denominator (shares outstanding), earnings can rise (everything else being equal). Bloomberg reported that the level of share buybacks are so high that corporate quality is deteriorating [emphasis added]:

“The trend of improving credit quality has slowed as profits are slowing,” Ben Garber, an economist at Moody’s Analytics in New York, said in a telephone interview. “As the recovery matures, companies are liable to get more aggressive in taking on share buybacks and dividends.”

Rather than using cash to pay down debt, companies in the S+P 500 Index are attempting to boost their share prices by buying back almost $700 billion of stock this year, approaching the 2007 record of $731 billion, said Rob Leiphart, an analyst at equity researcher Birinyi Associates in Westport, Connecticut.

Borrowers controlled by buyout firms are on pace to raise more than $72.7 billion this year through dividends financed by bank loans, surpassing last year’s record of $48.8 billion, according to S+P Capital IQ Leveraged Commentary & Data.

After cutting expenses as much as they could to improve profitability, companies “will need to see further revenue growth to boost earnings from here,” Anthony Valeri, a market strategist in San Diego with LPL Financial Corp., which oversees $350 billion, said in a telephone interview.

The good news: Ursa Minor
All these factors add up to bad news for the stock market. The good news is that any pullback is likely to be relatively minor and the possibility of a market crash is remote. The Fed has made it clear that it continues to be “data sensitive” and will adjust policy as necessary.

Translation: The Bernanke Put still lives.

Relief rally: Mind the gap(s)
My inner investor has already pulled back to a position of defensiveness. My inner trader, on the other hand, is watching the relief rally for an entry point on the short side. I am indebted to Tim Knight for his idea of watching the charts of HYG, JNK and MUB to watch for rallies up to fill the downside gaps. The theory is that stocks often see trading gaps filled after a price reversal, just as we are seeing now. After that, the down trend would continue. Tim Knight put it more colorfully than I ever could:

There are three ETFs I am watching very closely for gap closes. My motivation is twofold: first, I want to short the everloving bejesus out of them once the gaps are filled, and second, it’s going to be my signal to go balls-out shorting the equities in general.

As I write these words, the gaps in HYG, JNK and MUB have been filled. However, my inner trader is not ready to short “the everloving bejesus” out of this market yet. He is more inclined to pivot from a pure US-centric view to a more global macro view of the world and he is watching how the gaps in the ETFs of some of the aforementioned sectors that were affected by the Fed’s QE actions are resolving themselves.

Consider TLT, the long Treasury ETF, which has not rallied sufficiently to fill the (tinted) gap:

DBV, which is the ETF representing the currency carry trade, has seen its gap filled.

The emerging market ETFs have had their gaps either filled or mostly filled. Here is the chart for EM bonds (EMB):

Here is EM equities (EEM):

Here is China (FXI), which has been a focus of the markets in the past couple of weeks:

Commodity ETFs, however, aren’t performing that well and they continue to be in a downtrend without rallying to fill their gaps. Here is DBC, as a representative of the entire commodity complex. DBC violated a key support level and continues to weaken. It has seen no rally attempt to fill in its gap.

Gold (GLD) is one of the ugliest charts of all. Note, however, how it rallied back in April and May to fill in the gap (shown in green) but it continues to weaken and has shown two gaps (in yellow) that have yet to been filled in a relief rally.

The currencies of commodity-linked economies are behaving badly. Here is the Aussie Dollar:

Here is the Canadian Dollar, which is continue to decline with an unfilled gap:

What about Europe? The chart of FEZ representing eurozone equities below shows that while we have seen a minor relief rally, eurozone equities have not rallied up to fill its gap.

Here’s the score. Sectors with filled gaps: 3; unfilled gaps: 2. My inner trader’s conclusion is that the relief rally isn’t quite finished yet. We are likely to see several weeks of volatility before the process is complete before the longer term fundamentals of the recalibration of risk premiums pushes asset prices lower.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The fact that the Fed telegraphed its decision to begin tapering QE later this year, assuming that the current trajectory of economic data holds, was not an enormous surprise to me. However, the combination of the Fed decision, bad China data overnight and a liquidity squeeze in China have served to exacerbate the global market selloffs as I write these words.

Is this just a minor correction or the start of something worse? These are some technical lines in the sand that I am watching. First of all, the decline in the SPX has been contained at its 50-day moving average in the recent past. Can support at the 50 dma, which is at about 1618 hold?

As well, bond yields have been spiking in the wake of the FOMC decision. Past surges in 10-year Treasury yields have been contained at about the 2.4% level. Can 2.4% hold?

Bearish trigger in Europe
I have also been relatively constructive on European equities and believe it to be a value play. Despite the negative tone on the markets, eurozone PMIs have surprised on the upside (via Business Insider):

I wrote that past declines in European equities have been contained at its 200 day moving average (see The bear case for equities). Can the 200 dma hold?

Bearish trigger in emerging markets
In China, the combination of poor June flash PMI and a liquidity crunch have served to throw the markets into a tizzy. Zero Hedge reports that overnight repo rates spiked to 25%, which is evocative of the market seizures seen during the Lehman Crisis.

At this point, we don’t know if this credit crunch is deliberate or if the Chinese authorities have lost control of the interbank market (see FT Alphaville discussion). Michael McDonough sounded the alarm about the possible negative effects of this credit crunch on Chinese growth:

Should the Chinese credit crunch get out of control and start to spill over into the global markets, we should see the first signs of it in emerging market bonds. I wrote to watch the relative performance ratio of the emerging market bond ETF (EMB) against US high yield (HYG), which is testing a key relative technical support level (see An EM yellow flag):

I had written in the past to watch the price of the Chinese banks listed in HK as warning signs (see The canaries in the Chinese coalmine). That indicator may have lost some of its power as Reuters reported on Monday that the Chinese authorities have stepped in to increase their stake the state banks in order to “boost confidence”:

China’s government has stepped up efforts to lift confidence in the country’s flagging stock markets by buying more shares in the four biggest commercial banks, stock exchange statements showed on Monday.

This is the third time Huijin has been known to be buying shares in the secondary market since June 13, when China’s stock market skidded to six-month lows after data showed the world’s second-biggest economy was cooling faster than expected.

Watch the tripwires!
In summary, I wrote on Monday that my Trend Model had moved to “neutral” from “risk-on” (see Is the correction over?). For now, I am in watch and wait mode and monitoring these bearish tripwires before I go into full-flown “risk-off” mode:

Can the 50 dma hold for the SPX?

Can the 10-year Treasury yield breach the 2.4% level?

Can decline in the STOXX 600 be arrested at the 200 dma?

Will emerging market bonds melt down?

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Like this:

All it took was someone to whisper “Fed tapering” and volatility has returned with a vengeance to the markets. I explored this topic in late April (see Sell in May?) and outlined various criteria for getting bearish. For now, most of them haven’t been met, which means that I am still inclined to give the bull case the benefit of the doubt.

Surveying the Big Three global economies (US, Europe and China), I see signs of healing – which suggest that markets are likely to continue to grind higher, albeit in a volatile fashion. Let’s take the regions one by one.

US: Muddling through
As I mentioned, I outlined a number of bearish tripwires in my previous post Sell in May?

Earnings getting revised downwards, or more misses in earnings reports;

More misses in the high frequency economic releases;

Major averages to decline below their 50 dma; and

Failure of cyclical sectors to regain their leadership and defensive sectors to outperform.

With the exception of high frequency economic release data, none of the aforementioned tripwires have been triggered. The chart below shows the decline in the Citigroup Economic Surprise Index, but my own personal impression of high frequency economic data is that the results have been mixed. Even then, bad news may be good news as a weakening economy may provide the impetus for the Federal Reserve to delay any tapering of QE-infinity.

We will have a major test of market psychology this Friday. Supposing that the Non-Farm Payroll misses expectations, will the markets react positively because it is another data point supportive of further QE, or negatively because employment isn’t growing as expected?

In the meantime, the major market averages remain in a well-defined uptrend. So why are traders so skittish?

In fact, market participants have been so skittish that it only took a minor decline in the major averages for the percentage of bulls from the AAII survey to tank from a crowded long reading (chart via Bespoke). This kind of nervousness do not typically mark major market tops.

In late April, I also wrote that the bearish case also depended on the continued leadership of the defensive sectors and for cyclical sectors to continue to underperform. Well, those trends reversed themselves dramatically in the month of May. The relative performance chart below of Utilities (XLU) and REITs (VNQ) against the market shows that defensive and yield related sectors took a huge hit in the month:

Meanwhile, cyclical sectors as measured by the Morgan Stanley Cyclical Index have started to turn up against the market. What’s more telling is the fact that cyclical sectors performed well in Friday’s market selloff.

Europe: The next step in the Grand Plan
Across the Atlantic, I am seeing signs of healing in Europe (see Europe healing?) What’s more important is the fact that eurozone leaders are taking steps beyond pure austerity measures to address their structural problems.

Recall during the eurozone crises, many analysts said that there were only two solutions to eurozone problems, which was a competitiveness gap between the North and South. Either Greece (or insert the peripheral country of your choice here) leaves the euro and devalues to regain competitiveness, or the North (read: Germany) makes an explicit political decision to subsidize the South. It appears that the latter is happening (from The Guardian) and the focus issue is youth unemployment:

The French, German and Italian governments joined forces to launch initiatives to “rescue an entire generation” who fear they will never find jobs. More than 7.5 million young Europeans aged between 15 and 24 are not in employment, education or training, according to EU data. The rate of youth unemployment is more than double that for adults, and more than half of young people in Greece (59%) and Spain (55%) are unemployed.

But a new way of thinking has recently taken hold in the German capital. In light of record new unemployment figures among young people, even the intransigent Germans now realize that action is needed. “If we don’t act now, we risk losing an entire generation in Southern Europe,” say people close to Schäuble.

The new solution is now direct country-to-country assistance instead of assistance through the usual EU institutions [emphasis added]:

To come to grips with the problem, Merkel and Schäuble are willing to abandon ironclad tenets of their current bailout philosophy. In the future, they intend to provide direct assistance to select crisis-ridden countries instead of waiting for other countries to join in or for the European Commission to take the lead. To do so, they are even willing to send more money from Germany to the troubled regions and incorporate new guarantees into the federal budget. “We want to show that we’re not just the world’s best savers,” says a Schäuble confidant.

The initial focus of the direct assistance is Spain:

Last Tuesday, Schäuble sent a letter to Economics Minister Philipp Rösler in which he proposed that the coalition partners act together. “I believe that we should also offer bilateral German aid,” he wrote, noting that he hoped that this approach would result in “significant faster-acting support with visible and psychologically effective results within a foreseeable time period.”

Schäuble needs Rösler’s cooperation because the finance and economics ministries are jointly responsible for the government-owned KfW development bank. The Frankfurt-based institution is to play a key role in the German growth concept that experts from both ministries have started drafting for Spain. Spanish companies suffer from the fact that the country’s banks are currently lending at only relatively high interest rates. But since it is owned by the German government, the KfW can borrow money at rates almost as low as the government itself. Under the Berlin plan, the KfW would pass on part of this benefit to the ailing Spanish economy.

This is how the plan is supposed to work: First, the KfW would issue a so-called global loan to its Spanish sister bank, the ICO. These funds would then enable the Spanish development bank to offer lower-interest loans to domestic companies. As a result, Spanish companies would be able to benefit from low interest rates available in Germany.

The concerns over youth unemployment isn’t new. ECB head Mario Draghi spoke about the structural problems relating to youth unemployment in early 2012 (see Mario Draghi reveals the Grand Plan). In a WSJ interview, Draghi discussed what he believed it took to solve the youth unemployment problem [emphasis added]:

WSJ: Which do you think are the most important structural reforms?

Draghi: In Europe first is the product and services markets reform. And the second is the labour market reform which takes different shapes in different countries. In some of them one has to make labour markets more flexible and also fairer than they are today. In these countries there is a dual labour market: highly flexible for the young part of the population where labour contracts are three-month, six-month contracts that may be renewed for years. The same labour market is highly inflexible for the protected part of the population where salaries follow seniority rather than productivity. In a sense labour markets at the present time are unfair in such a setting because they put all the weight of flexibility on the young part of the population.

The first step in the Grand Plan was to gradually go after all the entrenched interests of people with lifetime employment and their gold-plated pension plans, etc. In other words, get rid of the European social model:

WSJ: Do you think Europe will become less of the social model that has defined it?

Draghi: The European social model has already gone when we see the youth unemployment rates prevailing in some countries. These reforms are necessary to increase employment, especially youth employment, and therefore expenditure and consumption.

WSJ: Job for life…

Draghi: You know there was a time when (economist) Rudi Dornbusch used to say that the Europeans are so rich they can afford to pay everybody for not working. That’s gone.

Now that they are taking steps to clean out the deadwood, the next thing to do is to plant, i.e. directly address the youth unemployment problem. These are all positive structural steps and, if properly implemented, result in a new sustainable growth model for Europe.

In the meantime, the Euro STOXX 50 staged an upside breakout in early May and, despite the recent pullback, the breakout is holding:

Stabilization in China
The bear case for China is this: The leadership recognizes that the model of relying on infrastructure spending and exports to fuel growth is unsustainable. It is trying to wean the economy off that growth path and shift it to one fueled by the Chinese consumer. Moreover, it has made it clear that given a choice between growth and financial stability, the government will choose the latter. This was a signal that we shouldn’t expect a knee-jerk response of more stimulus programs should economic growth start to slow down.

Indeed, growth has slowed as a result. The non-consensus call I recently wrote about is that China seems to showing signs of stabilization (see Even China join the bulls’ party). Since that post, further signs of stabilization is also coming from direct and indirect indicators of Chinese growth. First and foremost, China’s PMI came out late Friday and it beat expectations (from Bloomberg):

China’s manufacturing unexpectedly accelerated in May, indicating that a slowdown in economic growth in the first quarter may be stabilizing.

The Purchasing Managers’ Index rose to 50.8 from 50.6 in April, the National Bureau of Statistics and China Federation of Logistics and Purchasing said in Beijing yesterday. That was higher than all estimates in a Bloomberg News survey of 30 analysts and compares with the median projection of 50, which marks the dividing line between expansion and contraction.

Moreover, the KOSPI in nearby South Korea, which exports much capital equipment into China, is behaving well. This is somewhat surprising as South Korea competes directly with Japan and the deflating Japanese Yen is undoubtedly putting considerable pressure on the competitiveness of Korean exports:

Other indirect indicators of Chinese demand such as commodity prices are stabilizaing. Dr. Copper rallied out of a downtrend and appears to be undergoing a period of sideways consolidation.

A similar pattern can be seen in the industrial metal complex:

Oil prices, as measured by Brent (the real global price), is also trying to stabilize:

Key risks
In summary, the overall picture seems to be one of stabilization and recovery around the world. In such an environment, stock prices can continue to move higher in a choppy fashion. There are, however, a number of key risks to my outlook:

US macro surprise: If we get an ugly NFP this Friday and further signs that US macro picture is slowing, it will negatively affect the earnings outlook and deflate stock prices.

Japan: John Mauldin has a succinct summary of the issues facing Japan that I won’t repeat but you should read (see Central Bankers gone wild). The issue of a blowup seems to be one of timing and a catastrophic outcome could be close at hand. With bond yields spiking, how will the economy adjust to rising rates? Already, Toyota has pulled a bond issue because of rising rates. Zero Hedge pointed out how JPM has postulated that “a 100bp interest rate shock in the JGB yield curve, would cause a loss of ¥10tr for Japan’s banks”:

The rise in JGB volatility is raising concerns about a volatility-induced selloff similar to the so called “VaR shock” of the summer of 2003. At the time, the 10y JGB yield tripled from 0.5% in June 2003 to 1.6% in September 2003. The 60-day standard deviation of the daily changes in the 10y JGB yield jumped from 2bp per day to more than 7bp per day over the same period.
As documented widely in the literature, the sharp rise in market volatility in the summer of 2003 induced Japanese banks to sell government bonds as the Value-at-Risk exceeded their limits. This volatility induced selloff became self-reinforcing until yields rose to a level that induced buying by VaR insensitive investors.

An emerging market blowup and subsequent financial contagion: The hints of Fed tapering have negatively affected the emerging market bond market and they are starting to roll over against Treasuries. I am monitoring this chart of emerging market bonds against 7-10 Treasuries carefully for signs of market stress and contagion.

The Short Side of Long has indicated that, in general, sentiment towards equities remain at frothy levels which suggests that a short-term pullback may be in order, However, I am still inclined to stay long equities on an intermediate term basis and give the bulls the benefit of the doubt, but at the same time watching over my shoulder for signs of trouble.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Shortly after the market closed, the WSJ published Jon Hilsenrath’s article Fed Maps Exit From Stimulus in which the Fed discusses a gradual withdrawal of QE:

Federal Reserve officials have mapped out a strategy for winding down an unprecedented $85 billion-a-month bond-buying program meant to spur the economy—an effort to preserve flexibility and manage highly unpredictable market expectations.

No doubt the markets will get spooked by this “leak” and as I write these words, ES futures are moderately in the red. The question is, “How much and how far?”

Watch gold for clues to market direction
For me, the canary in the coalmine is the gold price, which is highly sensitive to expectations of monetary stimulus. Gold has staged a tactical V-shaped bottom and the silver/gold ratio has stabilized, which is constructive (see Watching silver for the bottom in gold). Gold rallied to fill in the gap left by its free fall in April – so now what?

With the news that the Fed is starting to think about an exit from QE, the near term downside risk is evident. There are many opinions about the fallout of this “leak”. Josh Brown has two sides of the story. On one hand, he believes that with sentiment excessively bullish, we aretactically headed for a hard correction. On the other hand, he seems more relaxed longer term.

As for myself, I am watching for a re-test of the April lows in gold to see if that low can hold as a sign for the risk-on trade. Longer term, the April decline caused considerable short-term technical damage, but the long-term uptrend remains intact. The other key issue is whether the uptrend can hold here.

A Lost Decade or a “beautiful deleveraging”?
Will this Fed action be a repeat of the Japanese experience where the authorities go through ease-tighten cycles that caused ups and downs in stock prices? This will be a test of Ray Dalio’s beautiful deleveraging thesis where the United States has undertaken just the right mix of austerity, money printing and debt restructuring.

My view is that there is no such thing as a free lunch, not even for governments or central banks. Any action taken may have benefits, but also imposes costs, even if those costs are imposed upon others. So it is for the Fed. At the beginning of 2008, they had a small, clean, low duration (less than three years) balance sheet on assets. Today the asset side of their balance sheet is much larger, long duration (over 6 years), negatively convex, and modestly dirty as a result.

He went on to outline the risks [emphasis added]:

Fed tightening cycles often start with a small explosion where short-dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing rates. Fed tightening cycles often end with a large explosion, where a large levered asset class that was better financed, was not financed well-enough. Think of commercial property in 1989, the stock market in 2000 (particularly the NASDAQ), or housing/banks in 2008. And yet, that is part of what Fed policy is supposed to do: reveal parts of the economy that are running too hot, so that capital can flow from misallocated areas to areas that are more sound. At present, my suspicion is that we still have more trouble to come in banking sector. Here’s why:

We’ve just been through 4.5 years of Fed funds / Interest on reserves being below 0.5% — this is a far greater period of loose policy than that of 1992-1993 and 2002 to mid-2004 together, and there is no apparent end in sight. This is why I believe that any removal of policy accommodation will prove very difficult. The greater the amount of policy accommodation, the greater the difficulties of removal. Watch the fireworks, if/when they try to remove it. And while you have the opportunity now, take some risk off the table.

It is possible a steep decline in financial assets would ensue with the lowest part of the capital structure being hurt the most. TheFed has chased investors all in the same direction; into risk-seeking securities. Few care about “right-tail” events, but should investors decide to pare risk in reaction to a hint of ‘tapering’, the overshoot to the downside may surprise many. The combination of too many sellers, too few buyers, and dreadful (and declining) liquidity means a down-side overshoot is highly likely. It would provide the Fed with their answer as to whether they have been creating market bubbles.

It appears that the Federal Reserve is well aware of these risks. In a speech last week, Ben Bernanke said that the Fed was closely monitoring the market for signs of excessive risk appetite, such as reaching for yield [emphasis added]:

We use a variety of models and methods; for example, we use empirical models of default risk and risk premiums to analyze credit spreads in corporate bond markets. These assessments are complemented by other information, including measures of volumes, liquidity, and market functioning, as well as intelligence gleaned from market participants and outside analysts. In light of the current low interest rate environment, we are watching particularly closely for instances of “reaching for yield” and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move.

The Fed being aware of a problem is the first step. Whether they can either react, either preemptively or after the fact, in the correct manner is another problem.

I prefer to watch the golden canary in the coalmine to see how the markets react, or over-react to the news that the Fed is mapping out a plan to gradually withdraw from quantitative easing.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

I wrote that I had been watching the behavior of cyclical stocks for a signal that a correction may be starting (see Correction? Watch the cyclicals!) and we may have seen that signal yesterday.

Is the consumer getting into trouble?
Consider, for example, the relative performance of Consumer Discretionary stocks against the market as a measure of risk appetite. This sector began a relative uptrend against the market last August but declined through a relative uptrend yesterday. This move, in conjunction with the behavior of other key sectors, may signal the end of the risk-on trade for the time being.

I would also point out that we have seen two consecutive housing related releases come in below expectations (homebuilder sentiment and housing starts). The housing sector, which recently turned from a train wreck into a recovery, has been a mild economic tailwind for the economy and consumer. Cullen Roche at Pragmatic Capitalism is not as sanguine about the housing recovery as many other analysts:

I still don’t see the recovery in the various housing indices that many are raving about. To me, this looks almost exactly like what I’ve been predicting all along. A sideways market that is consistent with past bubble experiences. Think Nasdaq, Shanghai, Gold in the 80s, etc. In essence, it looks like a big L.

CNBC reported that Americans are tapping home equity again as home prices have bottomed and started to appreciate again. I believe that HELOCs have been one reason why consumer spending has held up well despite the increase in payroll taxes this year.

So what happens to the consumer if the housing price recovery were to pause here?

Cyclical stocks rolling over
Another measure of the risk trade is the behavior of cyclical stocks. Business Insider highlighted the fact that CAT, which is highly cyclically sensitive on a global basis, just posted some disappointing sales statistics:

This gives us a sense of capital equipment sales in various global regions, which in turn serves as a proxy for economic activity.

And the latest numbers aren’t good. Worldwide dealer sales accelerated in the three months ending in January. The North America and Asia/Pacific regions posted double-digit declines.

The chart below of the Morgan Stanley Cyclical Index against the market shows a pattern that is very similar to the Consumer Discretionary sector. Cyclical stocks have also violated a relative uptrend yesterday, which is another bad sign for the bulls:

I also don’t like how Dr. Copper is behaving:

Note that this is not a “dive in the bunker” bearish call, but a warning that it may be time to take some chips off the table and to re-balance portfolios toward a greater emphasis on risk control.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Last week, I wrote that traders looking for a correction should closely monitor the behavior of cyclical stocks (see Correction? Watch the cyclicals!). So far, cyclical stocks remain in a relative uptrend when compared to the market and their relative uptrend remains intact. There is no hint that a correction has begun.

What I do find unusual is that while the relative performance of cyclical stocks remain robust, the shares of commodity producers continue to lag. This is curious when resource stocks represent the most cyclically sensitive sectors of the stock market.

In addition, the price of gold is deflating despite the talk of currency wars. Gold is an alternate currency and should be a beneficiary under a scenario where global central banks engage in competitive devaluation. However, the price of gold is fallen so much that a dark cross, or death cross, is rapidly approaching.

Commodity producers washed out
In the past few months, gold stock investors have fared worse than holders of bullion. I have been a long advocate that gold bulls should hold bullion rather than the shares (see Where is the leverage to gold? as one of many examples of previous posts on this topic). However, we may be approaching a point where traders could tactically favor gold stocks over bullion.

The graph below show the ratio of the Amex Gold Bugs Index (HUI) against the price of gold charted on a weekly basis. I have further overlaid a 14-week RSI on the top panel. Note that weekly RSI is now below 30 indicating an oversold reading. Past oversold readings have marked points where gold stocks have outperformed gold. In addition, the HUI/gold ratio is nearing the bottom of 2008, when investors dumped gold stocks in a bout of panic selling.

An analysis of the relative performance mining stocks show a similar pattern. Mining stocks are also approaching a key relative support level marked by the 2008 panic bottom.

These charts suggest to me that mining stocks are getting washed out and they are poised for a reversal in the months ahead.

Within the resource and commodity producing sector, energy stocks show a more constructive relative performance pattern. The chart below of the relative performance of this sector indicate that energy stocks have rallied through a relative downtrend line, i.e. they’ve stopped underperforming and a reversal may be close at hand.

Based on this analysis, my inner investor tells me that it is time to start accumulating positions in energy and mining. My inner trader, on the other hand, wants to dip his toe in the energy sector, play the golds for a bounce and wait for the relative reversal in mining before committing funds.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

I haven’t had the time, but I had been meaning to write a reply to Barry Ritholz’s posts last week where he indicated that he believed that the secular bear market that began in 2000 was in the process of ending (see Explaining My Position on Secular Bear Markets). His caveat was:

I DO NOT KNOW IF ITS OVER. It could be, but I suspect it is not. I do think that it is in the process of coming to an end, and that’s why I used the baseball metaphor of in the 7th inning.

Note: “Coming to an end” does not mean over. I erroneously assumed most people would understand what “in the 7th inning” meant — to those folks overseas, an American game of baseball has 9 innings. The 7th inning means its late in the game, but there are still a few innings left to be played.

I would tend to agree with his assertion that we are much closer to the end than the beginning of this secular bear, but I don’t think that it’s over for a couple of reasons:

Valuations: Stock market valuations have not declined sufficiently to levels where secular bulls have historically begun; and

Demographic effects on fund flows: The Baby Boomers are just starting to retire and take money out of stocks. Who are they going to sell to?

A long term look at stock market valuation
My favorite long-term valuation metric is Market Cap to GDP (via VectorGrader) as a rough proxy for the aggregate Price to Sales for the stock market. Market Cap to GDP, shown on the top panel, remains elevated relative to its own history. Secular bulls have historically begun when this measure has been depressed. In addition, note how falling Market Cap to GDP ratios have corresponded to secular bear markets, which have shown up as sideways markets.

The above chart of Market Cap to GDP only goes back to 1950, in which we have only had one episode of a secular bear, or sideways market. Barry Ritholz also showed, in a separate post from his secular bear post, a much longer history of this ratio that goes back to 1925 from Bianco Research. Market Cap to GDP remains highly elevated relative to its own history. That’s one reason why I don’t believe that a secular bull can start from current levels.

Indeed, Warren Buffett uses a similar ratio of Market Cap to GNP as a valuation measure for stocks. Cullen Roche at Pragmatic Capitalism pointed out that this metric has risen to levels that could only be called overvalued:

For the first time since the recovery began, Warren Buffett’s favorite valuation metric has breached the 100% level. That, of course, is the Wilshire 5,000 total market cap index relative to GNP. See the chart below for historical reference.

I only point this out because it’s a rather unusual occurrence and the recent move has been fairly sizable. It happened during the stock market bubble of the late 90′s, but then occurred again just briefly during the 2006-2007 period when the valuation broke the 100% range in Q3 2006 and stayed above that range for about a year. We all know what followed the 2007 peak in stock prices.

Demographic headwinds for stocks
Another reason for the continuation of a secular bear, or sideways stock market, is the outlook for fund flows. Simply put, stock prices rise when there are more buyers than sellers. So what happens when Baby Boomers in retirement or nearing retirement withdraw money from stocks? Can their children and grandchildren support stock prices at these price and valuation levels?

Until then, we will have to live with the ups and downs of a sideways and range bound stock market. Investors should therefore expect that the risk-on/risk-off environment should continue until the end of this decade.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

There is no doubt that tail-risk, or the risk of a catastrophic meltdown of the financial system, has fallen dramatically in the last couple of years. Consider that two years ago, Europe was mired in one summit after another over the eurozone financial crisis. In 2013, EU ministers are holding a crisis summit meeting over *gasp* horse meat (via The Telegraph):

The summit comes as supermarkets in Britain were urged by the Food Standards Agency to test pork, chicken and other meats for cross-contamination.

Meanwhile, Tesco has admitted that it had been selling frozen spaghetti bolognese ready meals which were between 60% and 100% horse meat.

Tomorrow’s meeting has been called by Ireland, which holds the EU presidency, and where the scandal began after horse meat was discovered in frozen beef burgers.

The country’s agriculture minister Simon Coveney said the summit was being held to discuss “whatever steps may be necessary at EU level to comprehensively address this matter”.

Measures on the agenda will reportedly include labelling processed meat for its origin. Meanwhile processed meat manufacturers in Ireland have been asked to carry out DNA testing in a bid to reassure consumers and export markets.

How times have changed.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.